Because it’s a fundamental principle of trading money management, one cannot neglect to define one’s trading float as well as one’s maximum trading entry. By defining our maximum trade loss prior to actually trading, we can ensure we keep losses at an absolute minimum. Likewise, our maximum trade loss should only account for a tiny portion of our trading float in order to safeguard ourselves in the event of multiple losses.
Unacceptably high risks are the primary reason for so many traders failing. Remember, the objective here is to keep losses at a minimum while at the same time allowing ourselves enough room for profits.
A very famous cricket captain once said that the most important aspect of the game, is not to make runs, but to stay in the game. I mention this because it’s so true with regards to trading as well. Your primary goal should be for you to protect your trading float just as that captain sought to protect his wickets. If you loose your float, you’re out of the game.
One of the great things about a sound trading psychology is that it instills in you, a sense of survival and a tendency to be defensive. Always thinking about the maximum losses you’re willing to incur doesn’t mean you’re being negative, it means you’re on the defensive.
Ed Seykota, a top trader, once gave his version of defining the three elements of modern trading:
1) Cutting your losses
2) Cutting your losses
3) Cutting your losses
He was also quoted as saying, “Follow these rules and you may just have a chance.
One fact that all traders need to be aware of is that experiencing some losses is inevitable in trade loss. When they occur, accept it and move on.
In all probability, you’re more than likely wandering how to define your maximum trade loss? Generally speaking, many traders tend to follow what’s known as the “2% Rule”, meaning you should never risk more than 2% on any given trade. However, many of the more seasoned professionals disagree with this as they feel it’s too high. Instead, these traders like to cap their maximum trade loss at 1% or lower. Admittedly, such a low maximum trade loss means no one single loss will have any noticeable impact on you but at the same time, your profits will also be low.
Perhaps a better way of putting the 2% rule into perspective would be for me to use an example. So, let’s say we start out with a float of $20,000 to which we apply the 2% rule. In this case our maximum loss on any given trade would be $400. As you can see, with your losses kept this low, it would take many losses to erode your float completely.
In fact, we would need to experience no less than fifty consecutive losses before loosing our entire float. Of course, you don’t need me to tell you just how unlikely it is that you’ll experience 50 losses in a row. Furthermore, because the 2% rule actually uses the current float amount rather than the initial float amount, you would need even more than fifty losses before being broke.
Let’s take a look at this in practice:
Starting with a $20K float we have our first loss based on the 2% rule. As we know, this would me we loose $400 which in turn leaves us with $19,600. Once again, we apply the 2% rule on our next trade, thus meaning the maximum loss we expect would be $392. Now let’s see what happens when life treats us really bad and we experience a string of six losses:
Float amount: $20,000
Float after 1st loss: $19,600
Float after 2nd loss: $19,208
Float after 3rd loss: $18,824
Float after 4th loss: $18,447
Float after 5th loss: $18,079
Float after 6th loss: $17,717
As you can see, even after a string of six losses, you’ll only have lost $2,283. In my opinion, this is proper risk management. Apply this knowledge to your trading and you’ll have a good chance of succeeding.